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Private Equity Deals Involving China Assets: Lawyers and Rep & Warranty Insurance

PitchBook reports that although 2022’s dry powder was lower than in either 2020 and 2021, a significant amount of capital has been deployed and remains to be deployed, including in deals involving Chinese companies and assets in China owned by US and non-Chinese companies. become We know this because we are part of some of these deals, as companies and investors try to make sense of the China market and predict the future there and in other promising markets.

An overview of venture capital versus private equity

In the venture capital and private equity space, “dry powder” means cash that has been committed to a fund by investors, but has not yet been called (transferred) or deployed (invested) by the fund.

These funds are cyclical in nature, usually with a 5-7 year investment horizon before liquidating the fund’s assets and starting a new fund. Successful VC and PE groups have multiple funds running simultaneously.

Funds tend to specialize in one or more geographic areas (eg China or Vietnam) and industries within those areas (LCD procurement) that often cut across geographic boundaries. In general, VC funds focus on early-stage companies, while PE funds focus on mid- to late-stage companies, often dealing with ownership transitions. Venture capital funds often take minority stakes, and it is not uncommon for private equity groups to take majority stakes.

What types of lawyers get involved?

All investment groups will work with one or more law firms that manage the legal side of their transactions. Some law firms are large enough to handle all deal flow from their PE or VC clients, while others require more than one firm. As a boutique international law firm, we are often called upon to work with law firms of all sizes that either do not have their own international team or lack the language or geographic expertise required to carry the entire transaction.

We work very well with other firms and divide the deal work based on our expertise. For deals involving Brazil, Mexico, China, Spain or Portugal, we have boots on the ground. For many other countries in South and Southeast Asia, LatAm, and Europe, we have both in-house competence and a large number of foreign languages ​​(more than 15) under our belt to make due diligence and correspondence easier.

How do lawyers help move a PE deal forward?

Sometimes PE to PE deals involve China or other international assets that are in operation for more than the life of a fund. And in other transactions, the seller’s management team does not have first-hand or significant legacy knowledge of the China or other international business operations.

This lack of institutional knowledge is problematic, mainly for the buyer. But it is also the seller’s issue to resolve if they want to sell the business without putting aside a large portion of the purchase price in escrow for indemnification obligations.

Buyer’s counsel will always insist on the broadest representations and warranties possible, and the buyer must be able to rely heavily on the seller. The seller’s attorney will never advise the seller to agree to representations and warranties that extend beyond the seller’s ownership involvement or current management’s involvement.

Representation & Warranty Insurance

In this potential impasse scenario, the buyer and seller will usually agree to obtain representation and warranty insurance (R&W). This allows the buyer to gain some peace of mind regarding the seller’s representations and warranties. And it gives the seller some peace of mind because the R&W insurer will be responsible for stepping in and making the buyer whole as the first line of defense in the indemnity bucket.

When R&W insurance comes into play, it will naturally be a matter of heated negotiation between the R&W insurer. And like all insurance policies, the terms of coverage will be reflected in the premium and the amount in the required indemnity bucket.

Obtaining R&W insurance does not obviate the need for buyer counsel to conduct robust due diligence. The R&W insurer requires a detailed due diligence memorandum or report from the buyer’s legal counsel. Often the questions – and especially the follow-up questions – are the most important service we provide because those inquiries lead to previously unknown documents and facts about the business.

We rarely find a smoking gun, but we almost always find information that the seller decided to “accidentally omit” or try to discard (such as unregistered IP, expired contracts, non-existent contracts, or misclassification of employees as independent contractors within an “acceptable level” of non-compliance).

Where do we go from here?

With China’s latest concession allowing Public Company Accounting Oversight Board (PCAOB) audits and its recent apparent success, it is possible that China may play more by the normal business rules. We are skeptical that this enforced compliance at the public company level (which includes about 200 Chinese companies listed on US exchanges) will trickle down to the private company level. As always when dealing with China, it is important to know who is on the other side of the deal and their tendency to follow the rules.

This is especially important for private equity firms who will need to provide their own representations and warranties in 5-7 years (or sooner) when they are ready to sell their portfolio’s China assets.

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